Week 11. Equity Valuation

Equity Valuation
Investment
Week 11, Chap 13

Apple and Alphabet Financial Highlights,
April 2017
Apple Alphabet
TABLE 13.1 Financial Price per share 142.71 844.04
highlights for Apple Common shares outstanding (billion) 5.25 0.70
and Alphabet Market capitalization ($ billion) 748.7 589.0
(Google) Latest 12 Months

Sales ($ billion) 218.12 90.27
EBITDA ($ billion) 69.75 29.86
Net income ($ billion) 45.22 19.48
Earnings per share 8.33 27.88
Valuation
Price/Earnings 13.92 30.28
Price/Book 5.67 4.20
Price/Sales 3.43 6.52
PEG 1.70 1.32
Profitability
ROE (%) 34.69 15.02
ROA (%) 11.85 9.41
Operating profit margin (%) 27.15 26.27
Net profit margin(%) 20.73 21.58
13.1 Equity Valuation
Book Value
• Net worth of common equity according to a firm’s balance
sheet
Limitations of Book Value

• Liquidation value: Net amount realized by selling assets of
firm and paying off debt
• Replacement cost: Cost to replace firm’s assets
• Tobin’s q: Ratio of firm’s market value to replacement cost
13.2 Intrinsic Value versus Market Price
(1 of 3)
E ( D1 ) + E ( P1 ) − P0 
Expected HPR = E ( r ) =
P0
E(D1) = expected dividend per share
P0 = current share price
E(P1) = expected end-of-year price
Example: Suppose you purchased a share of DAR Inc. for $40 in

January. You expect to sell it for $42 in December and expect to
receive a dividend of $2.42 during that year. What is your expected
HPR?
E (D1 ) + [E (P1 ) − P0 ] $2.42 + $42 − 40
HPR = E (r ) = = = .1105 = 11.05%
P0 40
(2 of 3)
Intrinsic Value
• Present value of firm’s expected future net cash flows
discounted by required RoR
Market Capitalization Rate

• Market-consensus estimate of appropriate discount rate
for firm’s cash flows
(3 of 3)
Intrinsic Value
E ( D1 ) + E ( P1 )
V0 =
1+ k
For holdingperiodH
D1 D2 DH + PH
V0 = + +.....+
1+ k (1+ k ) 2
( )
1+ k
H
Dividend Discount Model (DDM)

• Formula for intrinsic value of firm equal to present value of all
expected future dividends
13.3 Dividend Discount Models (1 of 4)
Constant-Growth DDM
• Form of DDM that assumes dividends will grow at constant rate
D1
V0 =
k −g
• Implies stock’s value greater if:
– Larger dividend per share
– Lower market capitalization rate, k
– Higher expected growth rate of dividends
For stock with market price

= intrinsic value, expected holding period return
E ( r ) = Dividend yield + Capital gains yield

D1 P1 − P0 D1
+ = +g
P0 P0 P0
Stock Prices and Investment Opportunities
• Dividend payout ratio

– Percentage of earnings paid as dividends
• Plowback ratio/earnings retention ratio

– Proportion of firm’s earnings reinvested in business
• Present value of growth opportunities (PVGO)

– Price = No-growth value per share + PVGO
E1
P0 = + PVGO
k
13.3 Dividend Growth and Reinvestment
Life Cycles and Multistage Growth Models
• Two-stage DDM
– DDM in which dividend growth assumed to level off
only at future date
• Multistage Growth Models

– Allow dividends per share to grow at several different
rates as firm matures
13.3 Dividend Discount Models:
Two Stage Example
Consider the following information:

• The firm’s dividends are expected to grow at g = 20% until t = 3 yrs.
• At the start of year four, growth slows to gs= 5%.
• The stock just paid a dividend Div0 = $1.00
• Assume a market capitalization rate of k = 12%
What is the price, P0, of this stock?

D0 × (1 + g) D0 × (1 + g)t D0 × (1 + g)t × (1 + g s )
P0 = +. . . + t
+
(1 + k) (1 + k) (1 + k)t × (k − g s )
$1 × (1 + .2) $1 × (1 + .2)2 $1 × (1 + .2)3
= + 2
+
(1 + .12) (1 + .12) (1 + .12)3
D0 × (1 + .2)3 × (1 + .05)
+
(1 + .12)3 × (.12 − .05)
= $1.07 + $1.15 + $1.23 + $18.45 = $21.90
13.3 Dividend Discount Models: Stock Value
The Constant Growth Model states that a stocks value will

be greater
• The larger its expected dividend per share.

• The lower the market capitalization rate, k.
• The higher the expected growth rate of dividends.
13.4 Price-Earnings Ratios (1 of 5)
Price Earnings Ratio and Growth Opportunities
• Price-earnings multiple
– Ratio of stock’s price to earnings per share
• Determinant of P/E ratio
P0 1 PVGO
= 1+
E1 k E1
k
P/E Ratio for Firm Growing at Long-Run Sustainable Pace
P0 1− b
=
E1 k − ( ROE × b )
PEG Ratio
• Ratio of P/E multiple to earnings growth rate
Table 13.3 Effect of ROE and Plowback on
Growth and P/E Ratio
P/E Ratios and Stock
P 1− b
=
E k −g
• All else equal, riskier stocks have lower P/E multiples, higher
required RoR, k
P/E Ratio and Inflation
FIGURE 13.3 P/E ratio of

the S&P 500 versus inflat
ion rate. Annual averages
,1955-2016.
Pitfalls in P/E Analysis
• Earnings Management
– Practice of using flexibility in accounting rules to
improve apparent profitability of firm
– Large amount of discretion in managing earnings
Figure 13.4 Earnings Growth for Two
Companies
Figure 13.5 Price-Earnings Ratios
Combining P/E Analysis and the DDM

• Estimates stock price at horizon date
Other Comparative Valuation Ratios

• Price-to-book: Indicates how aggressively market values
firm
• Price-to-cash-flow: Cash flow less affected by accounting
decisions than earnings
• Price-to-sales: For start-ups with no earnings
Figure 13.6 Valuation Ratios for S&P 500
13.5 Free Cash Flow Valuation Approaches
(1 of 4)
Free Cash Flow for Firm (FCFF)

• FCFF = EBIT(1 − tc) + Depreciation − Capital expenditures
− Increase in NWC
• EBIT = Earnings before interest and taxes
• tc = Corporate tax rate
• NWC = Net working capital
Free Cash Flow to Equity Holders (FCFE)

• FCFE = FCFF−Interest expense × (1 − tc) + Increase in net
debt
(2 of 4)
Estimating Terminal Value using Constant Growth Model
T FCFFt PT
Firmvalue = ෍ t
+ T
t=1 1 + WACC 1 + WACC
FCFFT+1
PT =
WACC − g
WACC = Weightedaveragecostofcapital
13.5 FCF Valuation Approaches:
FCFF Example
Suppose FCFF = $1 mil for years 1-4 and then is expected to grow at
a rate of 3%. Assume WACC = 15%
T
FCFF PT
Firmvalue = ෍ +
1 + WACC t 1 + WACC T
t=1
4 $1,000,000 × 1.03
$1,000,000 .15 − .03
=෍ +
1 + .15 t 1 + .15 4
t=1
= $7,762,527
If 500,000 shares are outstanding, what is the predicted price of this

stock if the firm has $5,000,000 of debt?
$7,762,527 − $5,000,000
P0 = = $5.53
500,000
(3 of 4)
Market Value of Equity
FCFEt PT
Market value of equity =  t =1
T
+
(1+ kE ) (1+ kE )
t T
FCFET +1
PT =
kE − g
13.5 FCF Valuation Approaches:
FCFE Example
Suppose FCFE = $900,000 for years 1-4 and then is expected to grow
at a rate of 3%. Assume ke = 18%
T
FCFE PT
Market Value of Equity = ෍ +
(1 + k e )t (1 + k e )t
t=1
4 $900,000 × 1.03
$900,000 .18 − .03
=෍ +
(1 + .18)t (1 + .18)4
t=1
= $ 2,500,851
If there are 500,000 shares outstanding, what is the predicted price of

this stock? Why can debt be ignored?
$ 2,500,851
P0 = = $5.00
500,000
Spreadsheet 13.2: FCF
(4 of 4)
Comparing Valuation Models

• Model values differ in practice
• Differences stem from simplifying assumptions
Problems with DCF Models

• DCF estimates are always somewhat imprecise
• Investors employ hierarchy of valuation
– Real estate, plant, equipment
– Economic profit on assets in place
– Growth opportunities
13.6 The Aggregate Stock Market
Forecasting Aggregate Stock Market
• Earnings multiplier applied at aggregate level

– Forecast corporate profits for period
– Derive estimate of aggregate P/E ratio based on long-
term interest rates
• Some analysts use aggregate DDM
Figure 13.7 Earnings Yield of S&P 500
versus 10 Year Treasury Bond Yield
S&P 500 Forecasts
TABLE 13.4 S&P 500 index forecasts under various scenarios
Pessimistic Most Likely Optimistic

Scenario Scenario Scenario
Treasury bond yield 3.0% 2.5% 2.0%
Earnings yield 5.4% 4.9% 4.4%
Resulting P/E ratio 18.52 20.41 22.73
EPS forecast 126 126 126
Forecasts for S&P 500 2,333 2,571 2,864
Note: The forecasts for the earnings yields on the S&P 500 equals the Tr
easury-bond yield plus 2.4%. The P/E ratio is the reciprocal of the foreca
st earnings yield.
Thank You

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Equity Valuation

Week 11, Chap 13

(Google) Latest 12 Months

Limitations of Book Value

Example: Suppose you purchased a share of DAR Inc. for $40 in

Market Capitalization Rate

Dividend Discount Model (DDM)

For stock with market price

E ( r ) = Dividend yield + Capital gains yield

Stock Prices and Investment Opportunities

• Dividend payout ratio

• Plowback ratio/earnings retention ratio

• Present value of growth opportunities (PVGO)

Life Cycles and Multistage Growth Models

• Multistage Growth Models

Consider the following information:

What is the price, P0, of this stock?

The Constant Growth Model states that a stocks value will

• The larger its expected dividend per share.

Price Earnings Ratio and Growth Opportunities

P/E Ratio for Firm Growing at Long-Run Sustainable Pace

P/E Ratios and Stock

FIGURE 13.3 P/E ratio of

Pitfalls in P/E Analysis

Combining P/E Analysis and the DDM

Other Comparative Valuation Ratios

Free Cash Flow for Firm (FCFF)

Free Cash Flow to Equity Holders (FCFE)

Estimating Terminal Value using Constant Growth Model

If 500,000 shares are outstanding, what is the predicted price of this

Market Value of Equity

If there are 500,000 shares outstanding, what is the predicted price of

Comparing Valuation Models

Problems with DCF Models

Forecasting Aggregate Stock Market

• Earnings multiplier applied at aggregate level

TABLE 13.4 S&P 500 index forecasts under various scenarios

Pessimistic Most Likely Optimistic

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